The discount rate often used in capital budgeting that

makes the net present value of all cash flows of a

particular project equal to zero.

Generally speaking, the higher a project's internal rate of
return, the more desirable it is to undertake the project.
As such, IRR can be used to rank several prospective
projects a firm is considering.

Assuming all other factors are equal among the various
projects, the project with the highest IRR would probably
be considered the best and undertaken first.

IRR is sometimes referred to as "economic rate of return
(ERR)".
Internal Rate of Return (IRR)
EC11
Modified Internal Rate Of Return MIRR

While the internal rate of return (IRR) assumes
the cash flows from a project are reinvested at
the IRR, the modified IRR assumes that all cash
flows are reinvested at the firm's cost of capital.
Therefore, MIRR more accurately reflects the
profitability of a project.
Internal Rate of Return: IRR
0 1 2 3
CF
0
CF
1
CF
2
CF
3
Cost Inflows
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.
( )
.
1
0
NPV
r
CF
t
t
n
t
=
+

=
( ) t
n
t
t
CF
IRR =

+
=
0 1
0.
NPV: Enter r, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
Calculate IRR
10 80 60
0 1 2 3
IRR = ?
-100.00
PV
3
PV
2
PV
1
0 = NPV
IRR = 18.13%.
40 40 40
0 1 2 3
IRR = ?
Find IRR if CFs are constant:
-100
IRR = 9.70%.
Depreciation

Depreciation may be defined as the decrease in the value
of physical assets with the passage of time as a result of
wear, deterioration and technological obsolescence.
It is used in the books of accounts for preparing a
balance sheet of assets.
Depreciation is viewed as a part of business expenses
that reduce taxable income.

Why Do We Consider Depreciation?
Depreciation Example
You purchased a car worth $15,000 at the beginning of year
2004.
D
e
p
r
e
c
i
a
t
i
o
n

End of
Year
Market
Value
Loss of
Value
0
1
2
3
4
5

$15,000
10,000
8,000
6,000
5,000
4,000

$5,000
2,000
2,000
1,000
1,000
p
Factors to Consider in Asset Depreciation
Depreciable life (how long?)

Salvage value (disposal value)

Cost basis (depreciation basis)

Method of depreciation (how?)
Salvage value is the price of an equipment
that can be obtained after it has been used.
What Can Be Depreciated?
Assets used in business or held for production of income

Assets having a definite useful life and a life longer than
one year

Assets that must wear out, become obsolete or lose value


A qualifying asset for depreciation must satisfy all of the
three conditions above.
Cost Basis
Cost of a new hole-punching
machine (Invoice price)

$62,500
+ Freight 725
+ Installation labor 2,150
+ Site preparation 3,500
Cost basis to use in depreciation
calculation
$68,875
Depreciation Methods

Straight-Line Method
Declining Balance Method
Unit Production Method
Straight Line (SL) Method
This method assumes a uniform decrease in the
value of asset with the passage of time.

Formula
Annual Depreciation
D
n
= (I S) / N, and constant for all n.

Book Value
B
n
= I n (D)
where I = cost basis/value
S = Salvage value
N = depreciable life
Book value is the
worth of an asset as
shown on the
accounting record of a
company.
Example Straight Line Method
D1
D2
D3
D4
D5
B1
B2
B3
B4
B5
$10,000
$8,000
$6,000
$4,000
$2,000
0
1 2 3 4 5

T
o
t
a
l

d
e
p
r
e
c
i
a
t
i
o
n

a
t

e
n
d

o
f

l
i
f
e

n D
n
B
n
1 1,600 8,400
2 1,600 6,800
3 1,600 5,200
4 1,600 3,600
5 1,600 2,000
I = $10,000
N = 5 Years
S = $2,000
D = (I - S)/N
Annual Depreciation
Book Value
n
Declining Balance Method
In this method the depreciation cost is highest in the
first year and reduces year after year.


Formula
Annual Depreciation


Book Value
1
=
n n
B D o
1
) 1 (

=
n
I o o
n
I B ) 1 ( o =
where 0 < o < 2(1/N)
Note: if o is chosen to be the upper bound, o = 2(1/N),
we call it a 200% DB or double declining balance method.
n
n
Example Declining Balance Method
D1
D2
D3
D4
D5
B1
B2
B3
B4
B5
$10,000
$8,000
$6,000
$4,000
$2,000
0
1 2 3 4 5
T
o
t
a
l

d
e
p
r
e
c
i
a
t
i
o
n

a
t

e
n
d

o
f

l
i
f
e

$778
Annual Depreciation
Book Value
n
0
1
2
3
4
5

D
n

$4,000
2,400
1,440
864
518
B
n
$10,000
6,000
3,600
2,160
1,296
778
I
N
S
D B
I
B I
n n
n
n
n
= $10,
= years
= $778
=
= ( -
000
5
1
1
1
1
o
o o
o

)
=

( )
n
o =.40
Example Declining Balance Method (if B<salvage value)
D1
D2
D3
D4
B1
B2
B3
B4
B5
$10,000
$8,000
$6,000
$4,000
$2,000
0
1 2 3 4 5
T
o
t
a
l

d
e
p
r
e
c
i
a
t
i
o
n

a
t

e
n
d

o
f

l
i
f
e

$778
Annual Depreciation
Book Value
n
0
1
2
3
4
5

D
n

$4,000
2,400
1,440
160
0
B
n
$10,000
6,000
3,600
2,160
2000
2000
I
N
S
D B
I
B I
n n
n
n
n
= $10,
= years
= $778
=
= ( -
000
5
1
1
1
1
o
o o
o

)
=

( )
n
2000
When S = $2,000
End of
Year
Depreciation Book Value
1 0.4($10,000) = $4,000 $10,000 - $4,000 = $6,000
2 0.4(6,000) = 2,400 6,000 2,400 = 3,600
3 0.4(3,600) = 1,440 3,600 1,440 = 2,160
4 0.4(2,160) = 864 > 160 2,60 160 = 2,000
5 0 2,000 0 = 2,000
Note: Tax law does not permit us to depreciate assets below
their salvage values.
Units-of-Production Method
Principle
Service units will be consumed in a non
time-phased fashion

Formula
Annual Depreciation

D
n
= Service units consumed for year
total service units
(I - S)
Example
Given: I = $55,000, S = $5,000, Total service
units = 250,000 miles, usage for this year =
30,000 miles
Solution:

30, 000
($55, 000 $5, 000)
250, 000
3
($50, 000)
25
$6, 000
Dep =
| |
=
|
\ .
=
Break-Even is the output level where total costs
equal total revenue.
Break-even analysis is a technique
used to estimate the number of units
which must be produced and sold for
a project to break-even.



Break Even Analysis
In business, revenue or revenues is income that a
company receives from its normal business
activities.
Profits or net income generally imply total
revenue minus total expenses in a given period.
Break-even analysis provides a simple
means of measuring profits and losses at
different levels of output

With this simple technique, a manager can
calculate the effect of different marketing
strategies and different pricing strategies on
the business.
The break-even point gives a business an
initial target at which to aim.
Drawing a Break-Even Chart

Quantity
Fixed costs
Total costs
Sales revenue
Break-even
output
Break-even
sales
break-
even
point
At the break-even point, total sales = total cost
(i.e. no profit or loss is made)
Margin of Safety

x units
Break-even
output
margin of
safety






The difference between actual output and the break-
even output is known as the margin of safety.
Break-Even Point
The point at which total costs are covered
and no profit or loss is made is called the
break-even point
the break-even point is where the total
revenue and total cost lines intersect on the
chart
this can also be calculated using the formula:

BEP = fixed costs
contribution per unit


To work out break-even we need to know various bits of information:

The price you are charging
The variable costs (direct costs) of each unit - these are the
costs of raw materials, labour and so on that can be directly
attributed to each unit.
The fixed costs (or indirect costs/overheads) - these are the
costs that stay the same whatever the level of output and will
be things like rent, marketing costs, admin costs and so on.

Once we have this information, we can work out the break-even
level of output. Let's look at an example:
Break-Even Calculation
Assuming that a product has a selling price of
6. Variable costs are 1 per unit and fixed
costs are 50,000 per year

Calculate the number of units that a firm must
sell in order to break-even

Answer - 50,000 = 1000 units
5
Uses of Break-Even Analysis
To calculate the minimum amount of sales required
in order to be able to break even
To see how changes in output, selling price or costs
will affect profit levels
To calculate the level of output required to reach a
certain level of profit
To allow various scenarios (what-if) to be tested out
To aid forecasting and planning
Limitations of break-even analysis
Its accuracy depends upon the accuracy of the data
used
Forecasting the future is difficult, especially long
term
It assumes there is a simple relationship between
variable costs and sales
Sales income does not necessarily rise in a constant
relationship to sales volume
Break-even does not specify a time that it will take
to reach this level. This will depend on how quickly
sales are generated.